Inflation targeting is a monetary policy strategy employed by central banks, such as the Reserve Bank of India (RBI), to maintain price stability while fostering economic growth. This approach involves setting a specific target for the inflation rate. In India, the aim is to maintain the Consumer Price Index (CPI) inflation at a central target of 4%, with a tolerance band of +/- 2 percentage points, allowing inflation to fluctuate between 2% and 6%.
Prior to 2015, India grappled with persistently high inflation that posed risks to economic stability. To tackle this issue, the government and the RBI formalized an inflation-targeting framework in 2015. The goal was to stabilize prices, align inflation expectations, and enhance the effectiveness of monetary policy. This agreement was subsequently codified in the amended RBI Act of 2016.
According to economists Barry Eichengreen and Poonam Gupta, inflation targeting has yielded positive results in India. Key outcomes include:
Despite its successes, inflation targeting has faced criticism, particularly concerning its reliance on food prices within the CPI inflation basket. Given the volatility of food prices, influenced by supply-side factors like monsoons and crop yields, critics argue that monetary policy may struggle to control these fluctuations effectively. Furthermore, there are concerns that strict adherence to the 4% target may restrict the RBI's flexibility to respond to broader economic challenges.
Chief Economic Advisor V. Anantha Nageswaran and others advocate for excluding food inflation from the RBI's rate-setting decisions. They contend that food prices are primarily driven by supply-side factors rather than monetary ones. Since the RBI's tools, such as interest rates, cannot directly affect these supply factors, adjusting monetary policy in response to food price volatility may not prove effective.
Economists warn against transitioning to a more discretionary monetary policy regime, where decisions are less rule-based. Such a shift could:
While the consensus is that the current 4% target with a +/- 2% band is suitable, some economists suggest minor adjustments could enhance effectiveness. For example, reducing the weight of food prices in the CPI basket might better reflect the inflation that monetary policy can influence.
The RBI Act was amended in 2016 to formalize the inflation-targeting agreement between the government and the RBI. The central inflation target remains at 4%, with a tolerance range of 2-6%. This target undergoes periodic reviews every five years, while the RBI's Monetary Policy Committee (MPC) is tasked with setting interest rates to achieve this goal.
The inflation-targeting framework proved resilient during economic shocks, such as the COVID-19 pandemic. Although inflation exceeded the upper tolerance limit of 6% between January and September 2022, largely due to global supply chain disruptions and food price shocks, the framework helped to prevent inflation from spiraling out of control.
As the inflation-targeting framework is slated for periodic review, future discussions may focus on adjusting the CPI basket to lessen the weight of food items, or enhancing the framework's flexibility. Nonetheless, experts generally agree that the core framework of targeting inflation has served India well and should be retained.
Inflation targeting has enabled India to achieve greater stability in inflation rates, anchored expectations, and improved the transmission of monetary policy. Although minor adjustments may benefit the framework, completely abandoning it could be adversely counterproductive. The potential risks of a more discretionary regime include loss of credibility, increased volatility in inflation, and inconsistencies in policy measures.
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